If you’ve never bought or sold stocks in the past, the thought of trading for the first time might be a daunting one. But, once you’ve done your homework and have developed the right habits, it’s not nearly as intimidating.
One of the key skills to learn is how to evaluate a stock. But first, here are some ground rules that can help put you in the best position to choose stocks for your portfolio.
First, you’re not simply buying a piece of paper. You’re buying into a company and its potential performance, among its other aspects. A stock is an ownership share in a company, so you might research a company’s financial info. When you invest, you gain an opportunity to join in on its success or failures over the long haul. Next, it’s time to learn how to calculate stock value.
The value of a stock is made up of several factors, including the company’s ability to continue making a profit, its customer base, the economy, political winds in the culture, its financial structure, and how the company fits within the industry. Understanding that will go a long way toward helping you select the right stocks for your portfolio.
Second, the more you know about the company, its industry, and general stock market trends, the better. Pro advice is important, but so is your common sense. As a consumer, you may be able to spot trends that eventually translate to a company’s strong performance down the line. Ask yourself: Why am I investing in this company? Why now?
Also remember, stock trading isn’t necessarily a passive “set it and forget it” strategy. Make time to review your stocks’ performance and watch the market on a regular basis. It’s important to assess your tolerance for risk before you start investing, too.
Finally, keep portfolio diversification in mind. It’s good to have a portfolio across a range of sectors and risks. Being invested in only one stock, means if the company fails, you could lose your invested money.
So, armed with these guidelines, let’s talk about how to calculate stock value. Here are four steps to evaluating stocks.
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Take a Look at the Balance Sheet and Other Financials
The Securities and Exchange Commission (SEC) requires all public companies to file regular financial documents that disclose their performance. The quarterly filings, which are essentially the company’s performance documents, indicate profit and loss, material issues that can affect performance, expenses, and other key information that will help you gauge a company’s health.
Take your time reviewing the documents. At first, they may seem like a foreign language, but soon you’ll pick up on the lines to key in on, such as revenue, operating expenses and non-operating expenses, total net income, and the earnings before interest, taxes, depreciation, and amortization (or EBITDA ). Here’s what to look for in each:
Income statement: You want to look at revenue, major expenses, and bottom-line income to find trends.
Balance sheet: This is where you can find out how the company treats debt. Did the company reduce or increase their debt? This can tell you a lot about a company’s performance.
Cash flow statement: Not all income is realized, so the cash flow statement shows you what the company actually got paid during the quarter, not what it’s expected to receive from sales 30, 60, or 90 days from now.
You’re looking for operating cash flows, that is, how income is generated by normal operations by the company, not some windfall or unusual influx of cash.
Say Hello to Your New Friends: the Financial Ratios
If learning how to evaluate a stock starts with analyzing financial statements, step two is understanding financial performance ratios. Ratios really help you hone in on a company’s financial health because they let you compare the company to others in the same industry or against the overall market.
Here are a handful of really helpful financial ratios you’ll want to come back to again and again:
Price-to-earnings ratio (P/E)
This is a stock valuation formula that will help you determine how a company’s stock price compares to another. The price-to-earnings ratio is exactly what it sounds like. It takes the market price of a company’s stock and divides it by the company’s earnings per share. The ratio can tell you how many years it will take for a company to generate enough value to buy back its stock.
Price-to-sales ratio (P/S)
The price-to-sales-ratio doesn’t factor in profit, which is helpful for valuing companies that haven’t made a profit yet or have a low level of profit. To get the ratio, you divide the market capitalization of the company by its revenue. Market cap is simply the value of all the company’s outstanding stock, in dollars. The P/S should be as close to one as possible. If it’s less than one, it’s considered excellent.
Earnings per share (EPS)
Earnings per share tell investors how much earnings each shareholder would receive if the company was liquidated immediately. Investors like to see growing earnings, and rising EPS means the company potentially has more money to distribute to shareholders or to roll back into the business. It’s calculated by taking net income, subtracting any preferred stock dividends, and dividing the result by the total number of outstanding common stock shares.
Return on equity (ROE)
Return on equity is a key guide for investors to measure the growth in profit for a company. Divide the company’s net income by the shareholders’ equity, and multiply by 100, to determine ROE.
Some investors like to see ROE rising by 10% or more per year, which reflects the performance of the
S&P 500 . The ratio tells you the value you would receive as a shareholder should the company liquidate tomorrow.
Debt-to-equity ratio (D/E)
Debt-to-equity is determined by dividing total liabilities by total shareholder equity. It gives investors an idea of how much the company is relying on debt to fund its operation. Essentially, it shows how well shareholders could cover liabilities if the company was liquidated.
A high debt-to-equity ratio indicates a company that borrows a lot. Whether it’s too high depends on a comparison with other companies in the industry.
Debt-to-asset ratio (D/A)
Too much debt can be a warning sign for investors. So how do you evaluate whether the stock you’re going to buy is carrying a reasonable amount of debt? The debt-to-asset ratio helps you compare the debt load with other companies, so you can better gauge, along with the other ratios, the riskiness of the investment.
Make Time for Some Good Old-Fashioned Reading
So, you’ve learned how to evaluate a stock you’re hoping to buy by analyzing their financial filings and employing a stock valuation formula or two to narrow your selection. If you’re wondering how to evaluate a stock further, you have one more step. Read.
There are hundreds, if not thousands, of helpful online news sites and tools to help you research companies, screen stocks, and model a stock’s potential in the future.
Consider staying with the major, name-brand companies for now, but if you see an interesting tool that you think will help you narrow down your choices—or uncover unexpected opportunities—by all means check it out. Below are some options to consider:
Financial News Sites
From the venerable Wall Street Journal to the ubiquitous Bloomberg service to industry-specific Food Business News, there are dozens of top, investor-trusted sites to help you learn more about how to calculate stock value.
Online Financial Tools
There are several stock screeners out there that are free to use, although some charge a subscription for higher levels of service. Stock screeners help you filter stocks according to the parameters you set. FINVIZ, Zacks, StockCharts, and the Motley Fool stock screeners are some to look into.
With all the tools available, there’s no reason you shouldn’t fully know how to evaluate a stock and its company’s performance.
Dedicate an Account for Stock Trading
One of the most frustrating financial mistakes investors make when they get serious about stock trading is commingling their investment savings with their regular finances. Consider creating a dedicated account, like a SoFi Invest account.
You’ll get complimentary access to financial advisors who can help you invest wisely and you can start with just $100. By doing your research, knowing how to use a stock valuation formula, and setting up your trading account, you’ll be set for many years of investing enjoyment.
Choose how you want to invest.
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The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member
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